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July 1, 2013

Nervous Global Markets but a Calm VIX: Where Do We Stand?

It seems to me that the global stock markets are a bit nervous these days. Japan’s Nikkei 225 had its first 6% daily loss in its 63-year history. In fact, this happened not once, but twice this year. China's GDP has slowed to 7.7% and its stock market has declined sharply. Europe is still in recession and the U.S. is trying to recover, but is still muddling along with GDP at 1.8%. Despite a weak economy, the U.S. stock market continues to trend higher and risk seems to be contained, at least for the moment.

Volatility

Risk, as measured by the CBOE Volatility Index, a.k.a. the VIX, is an indication of the level of risk present in the U.S. stock market. From January 2007 until the present time, it has averaged 23.6. On November 20, 2008, the VIX peaked at 80.9, the exact day the S&P 500 reached a temporary bottom of 752.40. I say temporary because it hit its post-crisis low of 676.50 on March 9, 2009.

In the past three years the VIX has had three major spikes. The first was on May 20, 2010, when it reached 45.8; the second was on August 8, 2011, when it hit 48.0, while the third was on October 11, 2011, when it topped 45.5. Each time, the stock market was falling. In fact, the correlation between the VIX and the S&P 500 for the period January 5, 2004 until the present is -0.59, indicating a strong negative correlation. Recently the VIX rose to 20.5, but has fallen back to 16.9 as of June 27th. Therefore, for now at least, it appears to be calm again.

Stocks

Even though the stock market has been trending higher, how much is due to Fed policy and how much is due to fundamentals? With the near meltdown of the global economy in 2008, stocks fell hard and fast. Maybe we had fallen so far that the rise over the past four years is neither excessive nor alarming. What I am sure of is that we are now in uncharted waters in terms of the degree to which central bankers are expanding their monetary systems. Perhaps the greater question is this: How will these 'Lords of Liquidity' unwind their QE programs without causing severe dislocations in the financial markets?

Summary

Consumers and businesses learned a great lesson in 2008: excessive debt can bring the house down and bubbles will eventually burst. As a result, I suspect they will be more cautious about returning to the same behavior that led to the crisis. However, the profit motive is a strong one and leverage is still an intensifier. This could prove to be an interesting ride!